The following scenario and analytical information describe a company. Three sets of facts are presented about this company. Perform a brainstorming analysis identifying all the factors that will affect the planning and conduct of the audit. Specifically, discuss in your group the following:
a. Based on the facts presented, what audit questions need to be addressed?
b. Based on the facts presented, what hypotheses can you develop about ways the company could be committing a fraud?
1. Company Background Facts. Brandon Apparel group is a manufacturer and wholesaler of apparel. The company was purchased five years ago by two young entrepreneurs and is heavily leveraged. The owners put up $400,000 of their own money and borrowed approximately $6 million to acquire the company from the previous owner. The owners tried to sell the company, but a due diligence review by the potential buyer indicated that some of the assets acquired in previous years did not exist. The company's debt is now over $10 million, equity is about $1.2 million (unaudited), and short-term payables are approximately $1.8 million. The company is relatively small with total sales last year of $13 million. Many of its customers are large, for example, JCPenney, SportMart, MC Sporting Goods, and Kohl's. The industry is competitive. The loan covenants require a debt-to-equity ratio not exceeding 3.5 to 1.0 and maintaining a tangible net worth above $1.5 million. Management fired the previous auditor and has asked you to perform the audit because you are local and know the company better. During the year, the company moved to licensing all of its goods rather than manufacturing them.
2. Industry and Analytical Analysis Facts. There is limited industry information available. The following reflects Brandon versus the industry for the current year:
Brandon Industry
Revenue increase %...........................................................12%..............................5%
Returns as % of revenue ...................................................3.4%...........................2.8%
Gross margin %................................................................28.5%..........................43.2%
Inventory-% of assets.....................................................58.4%.........................32.7%
Accounts receivable-% of assets.....................................22.8%........................18.2%
Cash-% of assets................................................................0.0%..........................4.3%
Intangibles-% of assets......................................................9.4%...........................7.4%
Other financial information: Although the company has shown revenue and profit growth, cash flow from operations has been negative for the past three years.
3. Management Information and Controls Facts. Management has determined that it needs to outsource most of the manufacturing to other companies under a licensing agreement. However, for this year, it will continue to record the total amount billed to the retailers as sales even though the licensing agreement provides only a 27.5% payment to Brandon. Next year, they will convert to only recognizing licensing fees as revenue.
Most of the large customers do not confirm accounts receivable. The company is implementing an automated bar-coded inventory system at the end of the year that they expect to be more accurate. The company will move the inventory to a new location after the end of the year, where it will be counted on January 8 when it is unloaded and scanned into the new inventory system.
4. Existence of Contra-liability. Management has sued the former owners of the company for the $1 million note that is still due to them. The suit alleges that assets originally sold to the owners five years ago did not exist and according to the contract, the owners have the right to offset the discovery of the nonexistent assets against the notes payable. Accordingly, the company has set up a contraliability account to show the offset with a corresponding increase in retained earnings.